Site Search Navigation

Site Navigation

Site Mobile Navigation

A message for regular readers of this blog: unless something big breaks later today, this will be my last day blogging AT THIS SITE. The Times is consolidating the process, so future blog-like entries will show
up at my regular columnist page. This should broaden the audience, a bit, maybe, and certainly make it easier for the Times to feature relevant posts.

It will also, for technical reasons, make my life simpler — you’d be surprised how many hoops I have to go through to get these things posted. But that’s not the reason.

Anyway, I expect to be doing the same sort of thing, mixing regular columns with stuff, usually wonkish, that doesn’t belong in the regular paper. Old blog posts will remain available!

Over the past couple of days we’ve had two very good critiques of the Tax Foundation “model” of tax cuts, which comes closer than any other to telling Republicans what they want to hear.

Greg Leiserson takes on TF’s bizarre treatment of the estate tax,
which should make no difference in the small-open-economy approach they claim to be following, but somehow becomes a huge growth factor in their analysis. Matt O’Brien follows up, among other things, on my point about leprechaun economics: If your claim is that tax cuts will induce
huge inflows of foreign capital, you should be projecting large future payments of income to foreigners, so that domestic income doesn’t grow nearly as much as GDP. TF somehow doesn’t.

So are there real-world examples of the latter issue aside from Ireland? Actually, yes — the so-called Visegrad economies of eastern Europe. These economies have attracted huge capital inflows from Western Europe, in part because of low wages, in part because of low corporate tax rates.
This has helped GDP grow — but national income has lagged, because so much of the growth has gone to foreign investors:

Average households have not seen enough of the fruits of economic growth. Those rewards have gone disproportionately to the owners of capital, and in these countries, that tends to mean foreigners. In the
Czech Republic, Hungary, and Slovakia, the most important sectors are largely or wholly foreign-owned.

You can see what this has meant for the Czech Republic in the figure. For what it’s worth, the lag of GNP behind GDP shown there is several times as large as most predictions of extra growth from U.S.
tax cuts.

Now, I don’t believe this tax “reform” will produce anything like the capital inflow its defenders claim. But even if it does, Americans won’t see much of the benefits.

Yesterday a former government official at a meeting I was attending asked a very good question: have any prominent Republican economists taken a strong stand against the terrible, no good, very bad tax legislation
their party just rammed through the Senate? I couldn’t think of any. And this says something not good about the state of at least that side of my profession.

We can divide Republican economists into three groups here. First are those enthusiastically endorsing the specific bill, like the 137 signatories of the letter Trump has tweeted out.
They’re a pretty motley crew, many not economists at all, some apparently nonexistent, and some with, um, interesting backgrounds:

Other names on the economists’ letter may raise eyebrows. John P. Eleazarian is listed as an economist with the American Economic Association. But membership to the AEA is open to anybody who coughs
up dues, and membership simply grants access to AEA journals and discounts at AEA events. Eleazarian is a former attorney who lost his law license and the ability to practice law in California after
he was convicted and sentenced to six months in prison for forging a judicial signature and falsifying other documents. His current LinkedIn profile lists him as a paralegal at a law firm.

Second are people like the Nine Unprofessional Economists – all of whom have, or used to have, real professional reputations, who signed that open letter asserting that corporate tax cuts might produce
rapid growth. As Jason Furman and Larry Summers pointed out, they misrepresented the research they claimed supported their position, then denied having said what they said.

The nine economists’ original Nov. 25 letterestimated that under the House and Senate proposals, “the gain in the long-run level of GDP would be just over 3 percent, or 0.3 percent per year
for a decade.”

…

The conservative economists wrote to Summers and Furman on Thursday, saying the 3 percent growth assertion “did not offer claims about the speed of adjustment to a long-run result.”

So that’s explicit aid and comfort to tax cutters, with an extra dose of dishonesty and cowardice.

OK, folks, this is basically to scratch my own intellectual itch — later this week Senate Republicans either will or won’t enact the biggest tax scam in history, and analysis won’t make
any difference. But inspired by the Furman-Summers beatdown of Republican economists lending cover to disgusting dishonesty by
their political masters, I found myself looking for a simple analytical representation of the effects of cutting corporate taxes. By simple, of course, I mean for economists: for anyone else this may as
well have been written in cuneiform. You have been warned.

OK, so the naive, super-optimistic version of what corporate tax cuts will do — roughly speaking the Tax Foundation version, without the incompetence — treats America as a small, perfectly open
economy that faces an infinite, perfectly elastic supply of foreign capital at some given rate of return. It also ignores leprechaun economics — the potentially large difference between GDP and national income when foreigners own a lot of your capital stock. Meanwhile, America is neither small nor perfectly open, so that the rate of return
to foreigners depends on how much capital we suck in — and since around a third of corporate profits already go to foreigners, they’re likely to collect a significant fraction of the gains
from a tax cut.

So, can we put all of that in a simple framework? I think we can. In fact, just one diagram, although for those not raised on traditional trade geometry it may look a bit intricate, But it’s all very
simple, believe me!

Starting point: we can think of a downward-sloping demand for capital, reflecting its marginal product. We can also think of an upward-sloping supply of capital, with the upward slope reflecting both the size
of the US — we’re probably around half of the world’s capital market not subject to capital controls — and the imperfect nature of capital mobility, even now.

We can think of corporate taxes as putting a wedge between the rate of return to capital before taxes — which is assumed equal to its marginal product — and the after-tax return received by investors.
So it’s kind of like an excise tax on capital, and looks like Figure 1:

A key part of the Senate tax bill is repeal of the individual health insurance mandate. The budget scoring relies on this repeal reducing Federal deficits by $318 billion — and the bulk of these spending cuts would hit lower-income families. Republicans argue, however, that these families won’t really
be hurt, because they’ll be making a voluntary choice not to be covered and collect government subsidies.

This argument might make sense in a world of hyper-rational individuals. In the world we actually live in, however, it’s a very bad argument. In fact, the very budget savings Republicans are counting
on depend on people making bad choices.

For if you look at CBO’s estimates of the savings from mandate repeal, more than half come from
a reduction in the number of people on Medicaid. Why wouldn’t someone eligible for Medicaid sign up for free insurance? The answer, surely, is that he or she isn’t aware of the option, or simply
fails to act in his or her self-interest.

If you think such things don’t happen, consider that one of the major triumphs of behavioral economics involves the demonstration that many people fail to take advantage of retirement plans that cost little or nothing — unless they’re automatically enrolled. If they are automatically enrolled,
but with the option of dropping the plan, enrollment is much higher than if they’re offered the same plan, but have to opt in. Sorry, but financial decisions like whether to get health insurance are
not made well, even by the well-educated and affluent, let alone the poorer, stressed people who are the main targets of GOP cuts.

Or consider the “woodwork effect” of the ACA: Medicaid enrollment increased even in states that didn’t accept Medicaid expansion, because greater publicity led some people to look into their
options and discover benefits they should have been collecting all along. (Not woodwork effect exactly, but I know people in New Jersey who tried to sign up for the exchanges and discovered that they had
long been eligible for Medicaid.)

So one main effect of the individual mandate is, in effect, to make Medicaid opt-out (at a cost) rather than opt-in; a lot of people who should have been getting the benefit won’t unless something like
this happens, and their failure to get the benefit is a true cost, not the result of a well-informed choice.

And of course it doesn’t stop with Medicaid: many of those collecting subsidies on the exchanges wouldn’t have done something that turns out to be a big advantage without the mandate in effect
forcing them to take a better look at their own self-interest.

Oh, and if you don’t believe any of this will happen, or it won’t happen on a large scale, then you can’t simultaneously believe in those $318 billion in savings.

So are reduced outlays on lower-income families a true cost to those families? Yes. Maybe not 100 cents on the dollar, but a lot closer to that than to zero.

The big economic policy story for this week will be the attempt to ram through the Republican tax bill, which manages both to raise taxes on middle- and lower-income Americans even as it blows up the debt, all
in the service of big tax cuts for corporations and the wealthy. To the extent that there’s any intellectual justification for this money grab, it lies in the conservative insistence that cutting
taxes at the top will magically produce huge economic growth.

That is, it’s still voodoo economics after all these years, and nothing — not the boom after Clinton raised taxes, not the failure of the Bush economy, not the debacle in Kansas — will change
the party’s commitment to a false economic doctrine that serves its donors’ interests.

But just behind the tax story is the effort to gut the Consumer Financial Protection Bureau; and this too needs to be understood in the context of a broader GOP commitment to a demonstrably false but useful
narrative.

Think about it: what would it take to persuade the right that financial deregulation is a bad idea, and some kinds of regulation are very good for the economy?

Modern financial regulation came about in the aftermath of the Great Depression, and — as you can see from the figure — the era of effective regulation was also an era of historically unprecedented
financial stability. Did this stability come at the expense of economic growth? Hardly: the era of effective regulation was also the era of the great postwar boom in America, the thirty glorious years in
Europe.

Nonetheless, by the 1970s a combination of free-market ideology and big money (with the latter helping to feed the former) produced a widespread belief among policymakers that those old regulations were pointless
and harmful. Regulations were lifted, and, maybe even more important, malign neglect allowed unregulated shadow banking to expand rapidly. (The Trump Treasury department wants global regulators to stop using the term “shadow banking”, which it says conveys the impression that there is something wrong with such institutions. Funny how causing the worst crisis since the 1930s can give you a bad reputation.)

Yes, I know that’s supposed to be an umlaut in the title. I just can’t persuade WordPress to do it.

So: There are many amazing things about the Republican tax pitch, where by “amazing” I mean terrible. But possibly the most amazing of all is the attempt to have it both ways on the question of
middle-class taxes.

The Senate bill, as written, tries to be long-run deficit-neutral — allowing use of the Byrd rule to bypass a filibuster — by offsetting huge corporate tax cuts with higher taxes on individuals,
so that by 2027 half the population, and most of the middle-class,
would see taxes go up. But those tax hikes are initially offset by a variety of temporary tax breaks.

Now, Republicans are arguing that those tax breaks won’t actually be temporary, that future Congresses will extend them. But they also need to assume that those tax breaks really will expire in order
to meet their budget numbers. So the temporary tax breaks need, for political purposes, to be both alive and dead.

If they succeed in this exercise in quantum budgeting, we’ll eventually open the box, collapsing the wave function, and discover whether the budget promise or the tax claim was a lie. But for now, they
want to hold it all in suspension. Once upon a time you wouldn’t have imagined they could get away with it. Now …

Yesterday the Tax Policy Center released its macroeconomic analysis of the
House tax cut bill. TPC is not impressed: their model says that GDP would be only 0.3 percent higher than baseline in 2027, and that revenue effects of this growth would make only a tiny dent in the deficit.

But Brad DeLong reminds me of a point I and others have been making: focusing on GDP is itself misleading, because we’re a financially open economy with a lot of foreign ownership already, and a large
part of the alleged benefit of corporate tax cuts is that they will supposedly draw in lots of foreign investment. As a result, we should expect a significant fraction of the benefits of corporate tax cuts
to go to foreigners, not domestic residents; income of domestic residents should rise less than GDP.

So I’ve been trying a back-of-the-envelope estimate of the difference leprechaun economics (so named
because Ireland is the ultimate example of a country where national income is much less than GDP, because of foreign corporations) makes to the analysis.

Start with the direct effects of a corporate tax cut. The JCT puts the revenue loss at $171 billion in 2027. Assume, as is roughly the consensus, that 1/3 of this accrues to
workers, but two-thirds to capital. Steve Rosenthal says that about 35 percent of this gain, in turn, accrues to foreign
investors. So right there we have about $40 billion in additional investment income paid to foreigners.

Then there are the effects of the trade deficit. I can’t figure out TPC’s estimate there, but typical numbers from other modelers say that we’re looking at around $80 billion a year, or
$800 billion in increased net foreign liabilities. BEA numbers say that foreign
investors in the US earn on average about 2%, U.S. investors abroad around 3%. So this suggests an average return of maybe 2.5%? My guess is that this is low, because the changes would be focused on direct
investment, which earns higher returns. But let’s go with it: in that case we’re talking about another $20 billion in investment income paid to foreigners.

Put it together, and for 2027 I get $60 billion in reduced GNI relative to GDP. Potential GDP is supposed to be about $28 trillion by then, so we’re
talking a bit over 0.2% of GDP.

Remember, TPC estimates the extra growth in GDP at 0.3%. So according to the back of my envelope, leprechaun economics — extra payments to foreigners — basically wipe out all of that growth.

And let me say that I am not entirely clear, given this result, why there should be any dynamic revenue gains. Given how scrupulous TPC normally is, they probably have an answer. But as far as I can see there’s
no obvious reason to believe that dynamic scoring helps the tax cut case at all, not even a little bit.

I’m sure that people can improve on my back-of-the-envelope here. But for now, it looks to me as if, properly counted, these tax cuts would do nothing for growth.

These are not good times, politically, for Republicans. The Virginia blowout showed that the Trump backlash is real, and will show up in actual votes, not just polls. A series of local elections have produced
Democratic victories in hitherto deep-red regions. Despite gerrymandering and the inherent disadvantage caused by concentration of minority voters in urban districts, Democrats are probably mild favorites
to take the House; thanks to Roy Moore, they even have a chance of taking the Senate, despite what was supposed to be an impossible map. “A wave is a’ coming”
says the Cook Political Report.

Add in, too, events that are likely to damage the GOP brand even more. There’s really no question about Trump/Putin collusion, and Trump in fact continues to act like Putin’s puppet. The only question
is how high the indictments will reach, and how much damage they’ll do. But it won’t be good.

You might think, given this background, that Republicans would moderate their policies in an attempt to limit the damage. But if anything they’re doing the opposite. The House tax bill is wildly regressive;
the Senate bill actually raises taxes on most families, while including a special tax break for private planes. In effect, the GOP is giving middle-class Americans a giant middle finger. What’s going
on?

A large part of the answer, I’d suggest, is that many Republicans now see themselves and/or their party in such dire straits that they’re no longer even trying to improve their future electoral
position; instead, it’s all about grabbing as much for their big donors while they still can. Freedom’s just another word for nothing left to lose; in the GOP’s case, that means the
freedom to be the party of, by, and for oligarchs they always wanted to be.

This calculus is clearest in the case of House members representing the kinds of districts — educated, relatively affluent, traditionally moderate Republican — that went Democratic by huge landslides
in Virginia. If 2018 ends up being anything like what now seems likely, these members will need new jobs in 2019 whatever they do — and the best jobs will be as K Street lobbyists, except for a few
who will get gigs as Fox News or “think tank” experts. In other words, one way or another their future lies in collecting wingnut welfare, which means that their incentives are entirely to
be loyal ideologues even if it’s very much at their constituents’ expense.

It’s a sad commentary on the state of affairs in America that we need to spend time debunking the Tax Foundation “model” of the effects of GOP tax cuts. But that model, with its extremely optimistic take on the growth and revenue effects of corporate tax cuts, is reportedly playing an important role in
Senate discussions. So let’s talk some more about a point I’ve been trying to make: if you believe the TF analysis, you also have to believe that the Senate bill would lead to enormous trade
deficits — and massive loss of manufacturing jobs.

TF provides very little detail on their model, which is itself a flashing red light: transparency is essential if you’re serious in this game. But if you read in a ways, there’s a table that tells
us some of what we need to know:

Photo

Credit

So they’re saying that in the long run — which they identify as a decade — the U.S capital stock will be 9.9% bigger than it would otherwise have been. Where do the savings for that increase
in capital come from? Since there’s nothing in the bill that would increase domestic savings — on the contrary, the budget deficit would reduce national savings — they come from inflows
of foreign capital.

How much inflow are we talking about? Currently, private fixed assets are approximately $43
trillion. A good baseline for private capital in 2027 would be to assume that it would grow with potential GDP. If so, in the absence of the Senate
bill private capital would be $65 trillion in 2027.

So the Tax Foundation is claiming that the Senate bill would raise that by 9.9%, or $6.4 trillion.

Now, it’s just an accounting identity that current account + financial account = 0 — that is, $6.4 trillion in capital inflows means an extra $6.4 trillion in trade deficits over the next decade,
more than $600 billion a year. Somehow, TF isn’t advertising that point, even though it’s an unavoidable conclusion from their analysis.

What would adding $600 billion per year to the trade deficit do? Mainly it would come from manufacturing, although part of that would reflect indirect losses in service industries that supply manufacturing.
So let’s say 60% comes from reduced value added in U.S. manufacturing. That’s more than 20% of U.S. value-added in manufacturing.
So the U.S. manufacturing sector would be around 20% smaller than it would have been otherwise.

I’m hearing from various sources that the Tax Foundation’s assessment of the Senate plan, which purports to show huge growth effects and lots of revenue gains from this growth, is actually having
an impact on debate in Washington. So we need to talk about TF’s model, and what they aren’t telling us.

The basic idea behind TF’s optimism is that the after-tax return on capital is set by global markets, so that if you cut the corporate tax rate, lots of capital comes flooding in, driving wages up and
the pre-tax rate of return down, until you’re back at parity. That is indeed a possible outcome if you make the right assumptions.

But there are two necessary side implications of this story. First, during the process of large-scale capital inflow, you must have correspondingly large trade deficits (over and above baseline). And I mean
large. If corporate tax cuts raise GDP by 30%, and the rate of return is 10%, this means cumulative current account deficits of 30% of GDP over the adjustment period. Say we’re talking about a decade:
then we’re talking about adding an average of 3% of GDP to the trade deficit each year — around $600 billion a year, doubling the current deficit.

Second, all that foreign capital will earn a return — foreigners aren’t investing in America for their health. As I’ve tried to point out,
this probably means that most of any gain in GDP accrues to foreigners, not U.S. national income.

So how does the TF model deal with these issues? They have never provided full documentation (which is in itself a bad sign), but the answer appears to be — it doesn’t. Judging from the description here,
the current version of the model has no international sector at all — that is, it says nothing about trade balances. They say that they’re working on a model that

tracks the effects of rapidly increasing or decreasing desired capital stocks on international capital markets. The international sector captures the capital payments that leave the domestic economy to the
foreign owners of domestic assets and adjusts the growth factors for the tax-return simulator to reflect the actual growth in incomes.

In other words, the model they’re using now doesn’t do any of that.

So while they’re peddling an analysis that implicitly predicts huge trade deficits and a large jump in income payments to foreigners, they’re using a model that has no way to assess these effects
or take them into account.

Maybe they’ll eventually do this stuff. But what they appear to be doing now is fundamentally incapable of addressing key issues in the tax policy debate.

Yesterday I noted that most discussion of the growth effects of the Cut Cut Cut Act, such as they may be, focuses on the wrong measure. GDP might go up because lower corporate taxes will draw in foreign capital; but this
capital will demand and receive returns, which mean that part of the gain in domestic production is offset by investment income received by foreigners. As a result, GNI – income of domestic residents
– will rise less than GDP. And surely, as in Ireland with its leprechaun economy based on low corporate taxes, GNI is the measure you want to focus on.

Now, inspired by Greg Leiserson’s post on problems with the Tax Foundation model –
the only one that shows significant growth effects from Cut Cut Cut – I think I can give an illustration of how much this might matter. It relies on a stylized version of the TF model, which is a
model I don’t believe for a minute, so this isn’t a real estimate. But it’s a sort of proof of concept.

So, as Leiserson says, the TF model assumes that thanks to international capital mobility there’s a fixed after-tax rate of return capital must earn. Cut the corporate tax rate, and capital flows in,
driving down the pre-tax rate of return by just enough to offset the tax cut.

The following figure shows the story. Here r* is the required rate of after-tax return, t is the initial tax rate, t’ the post Cut Cut Cut rate. MPK is the marginal product of capital curve. The tax cut
leads to a capital inflow that moves the economy down that curve. The rise in GDP is the integral of all successive increments to capital, so it’s the area a+b+c.

Photo

Credit

But the extra foreign capital, by assumption, receives the rate of return r*. So the area c is an addition to GDP but not to GNI; the true gain to the economy is only a+b.

Now let’s create some stylized numbers. It looks as if 8% is a reasonable number for after-tax
required return; with a 35% tax rate, this means a pre-tax rate of 12.3%. Cut the tax rate to 20%, and the pre-tax return should fall to 10%. The increment of capital should have a rate of return roughly
halfway between, 11.15%.

Tax Foundation asserts that capital inflows will be enough to raise GDP more than 3%, which is wildly implausible. But let’s go with it for the sake of argument. This means inflows of around 30 percent
of pre-CCC GDP.

So how much does this raise foreign investment income? The answer is, 8% times 30%, or 2.4 percent of GDP out of a GDP rise of 3.45 percent in my example. In other words, the true gain to the US is 1.05%, not
3.45%. That’s a big difference, and not in a good way.

The point is that even if you believe the whole “we’re a small open economy so capital will come flooding in” argument, it buys you a lot less economic optimism than its proponents imagine.

At one level, trying to have a serious discussion of the economic impacts of the Cut Cut Cut Act – sorry, the Tax Cuts and Jobs Act – is arguably a waste of time. Republicans who believe, or pretend
to believe, that tax cuts will produce an economic miracle, who didn’t change their minds after the Clinton boom, the Bush debacle, the Kansas disaster, and the strength of the economy after 2013
aren’t going to be persuaded by further analytical discussion.

But some of us have spent our lives trying to understand such things, and there are some intellectually interesting aspects of the current tax debate even though the would-be reformers aren’t interested
in a real discussion. So let me indulge myself.

The thing is, while Republicans always claim that tax cuts will produce miraculous growth, both the proposed tax cuts and the supposed sources of the miracle are a bit different this time. Instead of focusing
on individual tax rates – aside from the estate tax – this time it’s mostly about corporate taxes. And instead of claiming huge increases in work effort from lower marginal rates, they’re
mostly claiming that lower corporate taxes will bring huge capital inflows, raising wages and GDP.

There are multiple reasons to be skeptical about these claims; the actual magnitude of any positive effect on GDP is likely to be far smaller than anything Republicans say. The Penn-Wharton model says that GDP
in 2027 would be between 0.3% and 0.8% higher with the tax cuts than without, i.e., basically
an invisible effect against background noise; and this doesn’t even take into account the longer-run negative effects of discouraging higher education, slashing nutrition programs, and all the other
things that will probably happen due to higher deficits.

But let me make a different point: GDP is actually the wrong measure. If you’re going to be pulling in foreign capital, you’re going to be paying more investment income to foreigners; so gross
national income – income accruing to domestic residents – is going to go up by less. And surely that’s the measure we care about.

A lot, indeed most, of the action in the current tax fight will involve corporate taxes. And these are, unfortunately, a nasty, tricksy subject. In particular, right-wingers can appeal to a simple story that
sounds right until you pay closer attention.

The story goes like this: we’re an open economy, and part of a global capital market. So if you cut corporate taxes, capital will flow in, the marginal productivity of labor will rise, and so will wages.
And if you really believe the simple model, the wage gains could be pretty big.

But there’s tons wrong with that model. Some of it involves dynamics: how, exactly, does all this capital inflow take place, and how long does it take? But even the long-run analysis, done right, tells
you that the real impact on wages is far smaller than the usual suspects would have you believe.

The best analyses of the complications, as many have pointed out, come from Jennifer Gravelle . But many people may find it hard to extract the key intuition from Gravelle’s work; actually, I have found that intuition a bit hard to grasp, and while I’m not a real public finance
economist, I’m a lot closer to this stuff than 99% of readers.

So I thought I would try my own hand at offering some intuition here: why does Gravelle-type analysis “gear down” the wage effects of lower corporate taxes so much? There are, as I see it, four
reasons, three of which are conceptually easy, one a bit harder.

First, a lot of the profits we tax are rents on monopoly, brand identity, etc., and won’t be competed away by capital inflows.

Second, corporate capital is only part of the U.S. capital stock; half of fixed assets are residential, and a lot of the rest isn’t corporate. So we’re not cutting taxes on “capital”,
just on one particular type/use of capital.

Third, America isn’t small. Among market economies open to capital movement – i.e., excluding China – we’re still around 40% of world GDP at market values. So what we do will influence
global rates of return, a lot; we would face an upward-sloping supply curve for capital even if capital mobility were perfect.